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Chapter 26: Problem 3

Draw a demand and supply graph showing equilibriur in the money market. Suppose the Fed wants to lower th equilibrium interest rate. Show on the graph how the Fe would traditionally accomplish this objective.

Short Answer

Expert verified
A demand and supply graph of the money market can show how the Fed traditionally lowers the equilibrium interest rate - by buying treasury securities, thus increasing the supply of money. This shifts the supply curve to the right, resulting in a new equilibrium at a lower interest rate.

Step by step solution

01

Draw the initial supply and demand graph

To begin, construct a demand (D) and supply (S) graph with 'Quantity of Money' on the x-axis and 'Interest Rate' on the y-axis. The intersection of these two curves represents the initial equilibrium.
02

Analyze the Fed's influence

Understand that the Fed has the ability to influence the supply of money. When the Fed wants to reduce the interest rate, it traditionally implements a monetary policy tool known as open market operations: buying treasury securities in the open market to increase the supply of money.
03

Implement the Fed's action on the graph

Reflect the Fed's action on your graph. The purchase of treasury securities by the Fed increases the money supply, shifting the money supply curve (S1) to the right. As a result, we see a new equilibrium with a lower interest rate.

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Most popular questions from this chapter

What do economists mean by the demand for money? What is the advantage of holding money? What is the disadvantage? Why does an increase in the interest rate decrease the auantity of money demanded?

What are the key differences between how we illustrate an expansionary monetary policy in the basic aggregate demand and aggregate supply model and in the dynamic aggregate demand and aggregate supply model?

What is a monetary rule, as opposed to a monetary policy? What monetary rule would Milton Friedman have liked the Fed to follow? Why has support for a monetary rule of the kind Friedman advocated declined since \(1980 ?\)

(Related to the Apply the Concept on page 931) Suppose you buy a house for $$\$ 150,000 .$$ One year later, the market price of the house has risen to $$\$ 165,000$$. What is the return on your investment in the house if you made a down payment of 20 percent and took out a mortgage loan for the other 80 percent? What if you made a down payment of 5 percent and borrowed the other 95 percent? Be sure to show your calculations in your answer.

What are the Fed's four monetary policy goals? In what sense does the Fed have a "dual mandate"?
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